Magoosh GRE

Could Islamic Banking Avoid the Global Financial Crisis?

| March 3, 2015

1. Introduction
Following from the Second World War, a significant portion of development in the world economy can be attributed to the financial system (Chapra, 2008). The global financial system has been characterised by a continuous stream of financial innovations, such as the revolution of information and communications technology. These innovations have culminated to the development of the financial system, which has in turn resulted in the growth and development of many economies.

Despite this positive impact, financial systems across countries continue to suffer from repeated episodes of financial crises, which in tend undermine economic growth and development (Stiglitz, 2003). Examples include the Great Depression of 1929-1993, the European Monetary System Crisis, The Mexican Crisis, the Asian Financial Crisis, the Baring-Argentine Crisis, and the most recent global financial crisis. The period 2007-2009 suffered one of the most precarious crises in the annals of financial crises. Unlike previous crisis, it affected almost every region of the world with devastating consequences on the economy such as declining GDP, rising unemployment, high default rates on both sovereign and private debt, etc. The crisis has been attributed mainly to the rise and fall in the U.S housing market over the period 2003 to 2007. In other words, a boom-burst cycle in the U.S housing market is said to have contributed to the crisis. In addition, the securitisation and distribution of mortgage-backed securities, which were backed by sub-prime mortgage loans has been blamed for the financial crisis. This is because most the securities were backed by sub-prime loans. Sub-prime loans are loans that were made to people with very poor credit quality. Consequently, the default rate of the loans was very high. As house prices fell, loan-value ratios became higher than 1.0 thereby making it more beneficial for borrowers to default on their loans. Banks were therefore forced to repossess houses that were of a lower value to the loans that were backed by them. Banks were therefore forced into a liquidity crisis, which transformed into a financial crisis.
While most of these activities took place in the conventional financial system, the Islamic financial system operated in a completely different way. For example, Islamic banks are yet to adopt some of the complex financial innovations that have taken place in conventional banks. In addition, Islamic banks operate strictly under the guidelines of the Shiaria Law which preclude them from engaging in a number of risky transactions. Taking this into account, one is forced to ask whether the financial crisis could have been avoided by Islamic banks. This will be done by reviewing literature on the causes of the crisis, Islamic financial system and draw conclusions as to whether Islamic banking could have avoided the crisis. The rest of the paper is organised as follows: section 2 provides an overview of the global financial crisis, its causes, consequences and remedies; section 3 provides an overview of the Islamic financial system including its similarities and differences with the conventional financial system as well as discussions as to whether Islamic finance could have helped to avoid the global financial crisis; and section 4 provides general conclusions and recommendations.

2. Overview of the global Financial Crisis

The global financial crisis started in the United States in July 2007 following declining house prices and widespread default on sub-prime mortgage loans. Taking into account that most banks had positions in sub-prime mortgage loans as well as securities derived from these loans, banks were forced into difficult liquidity problems as the default on sub-prime loans resulted in the withdrawal of an important source of profitability and liquidity for banks.

So what were the causes of the crisis? The main cause of the crisis was significant exposure by banks to what has been described as high risk and below investment grade securities. During the housing bubbles period covering 2003 to 2007, banks and other major players in the financial system regarded mortgage backed securities as attractive source of profitability and liquidity. House prices were at their all-time high around the year 2005. As such the allocation of funds to real estate was considered one of the safest forms of investing. Investors regarded an investment in real estate as a guaranteed source of sustainable growth and stability in capital (Shiller, 2008).

Home ownership rates in the U.K witnessed significant growth during the year 2005. U.S census figures show that home ownership rates moved from 65.7 percent in 2004 to 68.9 percent in 2005, which translates to a rise in the number of owner-occupied homes by 11.5 percent over the period 2004 to 2005 (Shiller, 2008). In order to facilitate home ownership, banks became actively involved in the underwriting of mortgage loans. In addition, the fee paid for each mortgage sold became significantly high thereby motivating more banks to engage in the underwriting of mortgages (Crotty, 2008). Less attention was paid to risk. Rather, the decision to provide a mortgage loan was based mostly on the fees that were to be generated from the sales. Fees were paid based on the mortgage turnover rate. The credit quality of potential borrowers was not properly verified prior to the provision of a mortgage loan. As such loans were issued even to people with very low credit quality (sub-prime borrowers) thereby resulting in an increase in the inherent default risk of the mortgage loans (Crotty, 2008; Shiller, 2008). The default risk was however overlooked by most banks and major participants in the financial system. This is because the return generated from mortgages was significantly high and banks considered the risks worthwhile and continued providing mortgage loans to borrowers with low credit quality. Banks continued riding the band wagon, despite significant increases in mortgage default rates around mid-2005 (Mayer et al., 2008).

The situation was further exacerbated by the fact that the mortgage loans did not remain with the banks that had provided them. Each mortgage loan was securitised and repackaged into other more complex securities such as mortgage backed securities (MBS) and collaterised mortgage obligations (CMOs) and resold in the secondary market. MBS are securities that are backed by pools of morgagge loans. MBS include mortgage passthrough securities and CMOs. The main objective of securitising the mortgage loans was to create assets with different payment structures which in turn allowed banks to redistribute prepayment risk (Fabozzi., 2001).

The high rate of return associated with mortgage securitisation forced many financial institutions to change their business model. Most banks began using an “originate and distribute” business model which allowed them to originate risky mortgage loans in the primary mortgage market, repackaged them into MBSs and then distribute them to other market participants in the secondary mortgage market (Brunnermeier, 2009). The secondary market consisted mainly of investment banks and institutional investors. This means that the risk inherent in the primary mortgage loans was transferred from commercial banks to investment banks and institutional investors through securitisation in the secondary market (Brunnermeier, 2009). In other words, the “originate and distribute” model provided banks with an opportunity to offload risk (Berndt and Gupta, 2009).

The securitisation process took the following steps. Firstly, the banks began by creating a portfolio of the total outstanding loans. Different tranches were created from the portfolios depending on the default risk of each loan included in the portfolio. In other words, different tranches were created based on the credit quality of the portfolios. The second step was the sale of the different tranches to a variety of investor groups who were grouped based on their degree of risk aversion (Brunnermeier, 2009; Coral et al., 2009). To differentiate between different tranches, a credit rating is attached to each tranche depending on its default risk. The different slices (or tranches) are then classified in accordance to their assigned credit ratings. The portfolio with the least default risk is assigned a credit rating of AAA and is considered to be the most senior tranche while the most subordinated tranche is assigned least credit rating. The most senior tranches offers a low rate of return to its investors but this low risk of return is compensated for by the low default risk associated with the tranche. On the contrary, the most subordinated tranche carries a very high default risk which is compensated for by a high rate of return. Securitisation resulted in the sub-prime mortgage crisis in that most of the most subordinated tranches could not be resold in the secondary market. Most of these tranches contained mortgage loans that were issued to sub-prime borrowers who had difficulties repaying the loans. Consequently, banks were unable to receive payment from these borrowers. The immediate consequence was a liquidity crisis, which eventually led to a liquidit crisis because the government and central banks in the U.S and U.K were unwilling to offer banks with liquidity.
Banks suffered particularly because the structured securities were very complex, which made them difficult to value (Cecchetti, 2009). In addition, banks could not match the maturity of their liabilities to the maturity of assets. Most liabilities matured before assets. In other words banks depended on very short-term sources of finance to finance investments in long-term assets. This means that banks were required to make short-term principal and interest repayments on their outstanding loans. The cash flows necessary to service these loans were however expected to be generated from very short-term investments. The asset-liability mismatch therefore resulted to the liquidity crisis, which eventually transformed into the global financial crisis (Brunnermeier, 2009). A number of banks that were significantly affected by the crisis include Northern Rock in the U.K and Bear Sterns in the U.S. Both banks were actively involved in the “originate and distribute” process changing their usual business of banking to that of issuing buying and selling mortgage loans. Both Northern Rock and Bear Sterns faced significant liquidity crisis following the burst in the Housing bubble during the summer of 2007. Early warning signs of Bear Sterns vulnerability to the crisis came to light when its net income declined by 61 percent between June 2997 and August of the same year (BBC, 2008). The market value of the bank dropped from $158billion in April 2007 to $180billion in September the same year (BBC, 2008). The first-ever quarterly loss of Bear Sterns history was reported in December 2007 and this loss was attributed to a write down in the value of its outstanding mortgage-backed securities by $1.9billion. (Telegraph, 2008). The bank was taken over by JP Morgan in March 2008.
Like Bear Sterns, Northern Rock deviated significantly from its core business model to the “originate and distribute” model. Its liquidity depended significantly on the wholesale market for mortgage loans. Its core business was transformed from conducting day-to-day banking operations to the origination and distribution of mortgaged backed securities to other banks and financial institutions (Mizen, 2008; Canon, 2008; Yorulmazer, 2008). In August 2007, the whole sale market for mortgage loans became very tight and Northern Rock began facing liquidity problems. Attempts to secure emergency funding from the Financial Services Authority and the Bank of England (BoE) did not yield any fruitful results. As a result a run on the Bank was inevitable.
A number of studies have analysed the global financial crisis. Demanyank and Hermet (2008) employ loan level data to analyse the quality of sub-prime mortgage loans. The performance of the loans are adjusted in accordance with the performance for differences in borrower, characteristics, loan characterisitics and the appreciation of the house prices following the origination of the loan. The study observes that the loan quality declined for six consecutive years prior to the global financial crisis and that most banks that engaged in securitising mortgage loans were aware of these issues. This means that the global financial crisis did not merely occur because banks were unable to manage or control risks. The crisis occurred because banks became too greedy focusing all their energy on the potential returns with limited or no regard for risk. The study further contends that the sub-prime mortgage crisis follow a classic lending boom-burst cycle whereby unstable growth results to the collapse of the market (Demyank and Hermet, 2008). Unstable growth or a housing bubble in this case can be described as a situation whereby house price increases do not reflect their fundamental values. House prices depend significantly on fundamentals such as rent and disposable income. However, many studies have shown that the housing boom was not associated with a significant change in these fundamentals. This means that the boom was actually a bubble since it was not supported by the fundamentals that determine house price movements. Davidson (2008) argues that the crisis cannot be explained by Minsky’s theory of financial crisis. According to Minsky’s theory, in the normal course of a business cycle upswing, financing of new investments followed specific path from a conservative financing operation (hedge financing) towards more fragile financing (speculative and ponzi financing) of new projects. Therefore “over the course of any expansion, the economy moves from hedge to speculative to ponzi financing”. According to Minsky (1986, 1992) cited by Davidson (2008) this is a necessary precondition for an unstable financial system. Davidson (2008) observes that these preconditions were not present before the global financial crisis. Rather Davidson (2008) attributes the crisis to insolvency. He further contends that banks were trying to transform mortgages, which are normally illiquid assets into liquid assets. Since the process could not be sustained for long, it became ineluctable that banks were going to face a liquidity crisis which would eventually transform into the global financial crisis. From Davidson’s (2008) point of view, one possible solution to the liquidity crisis was to infuse new capital into financial institutions so as to enable them offload their non-performing mortgage loans. However, this strategy appears to have failed. Many governments and central banks engaged in easy fiscal and monetary policies following the global financial crisis. However, despite these efforts, there appears to be still some traces of the global financial crisis. Many economies are yet to recover fully from the crisis. The situation has been exacerbated in some countries. For example, many countries in the Eurozone are facing a debt crisis while the U.S.A has witnessed a decline in its credit rating. Taylor (2007) provides an evaluation of the crisis from a monetary policy perspective. The study observes a secular change in the housing cycle in the U.S over the past century. In particular, the study observes that the volatility or average fluctuations in residential construction declined over the past century. The decline in volatility is attributed to improved monetary policy. Some studies have attributed the crisis to the “originate and distribute” business model. Most of these studies attribute the liquidity constraints faced by Northern Rock during the run-up to the crisis to its business model, which employed the wholesale mortgage market as its main source of liquidity. Moreover, Northern Rock has been blamed for not hedging against the risk associated with the mortgages. (Hall, 2008; Hallsworth, 2008; Keasey and Veronesi, 2008; Mainelli, 2008; Hallsworth and Skinner, 2008).

3. Overview of Islamic Finance

The Islamic finance sector has witnessed tremendous growth over the last three decades. Today, more than 200 Islamic banks operate across 70 countries (Hassan and Lewis, 2007). Rahim and Rahman (2007) put the total number of worldwide Islamic banks to 270 and observe that the combined market capitalisation is more than 270 billion U.S dollars. The assets under the control of Islamic Banks averages over 400billion U.S dollars. As at 2007, Islamic bank deposits stood at approximately $202billion dollars with a growth rate of 20 percent per annum (Rahim and Rahman, 2007).
The growth in the Islamic finance sector has been influenced mainly by the demand for Islamic finance products by Muslims who find conventional banking products to be non-compliant with Sharia Law. Consequently, the Islamic finance sector has been developed to carter for the needs of this group of consumers. The last decade has witnessed tremendous growth in Islamic finance products and Islamic banks have been able to attract savings that would otherwise not been harnessed by the conventional banking system (Siddiqui, 2008).
Muslims are attracted to Islamic banks because they banks promise to provide them with financial products that comply with their religious principles. Furthermore, the Islamic banking sector contributes toward the achievement of major socio-economic goals of Islam (Hassan and Lewis, 2007). Most notably, the Islamic banking sector contributes to the economic well-being of Muslims providing with the opportunity to achieve full employment, high rates of economic growth, socio economic justice, equitable distribution of resources, preservation of capital, mobilisation of savings and investment, and the assurance of a just return on investment to investors in Islamic banking products (Hassan and Lewis, 2007).
Islamic finance products began as simple profit and loss sharing accounts. Today, the product base has grown to include hedge funds, bonds and derivatives. Some conventional banks in the Western World have diversified into the Islamic Banking sector owing to a growing demand for Islamic banking products by Muslims resident in these countries (Siddiqui, 2008; El-Qorchi, 2005). The growth in Islamic banks in the Western World can be attributed to an increasing number of immigrants and non-immigrant Muslims. This group of consumers have increasingly demanded products that are compliant with Sharia Law (El-Qorchi, 2005). In addition, growth in oil wealth in the Gulf region has increased the demand for suitable investment. Furthermore, Islamic finance products are becoming more competitive, attracting both Muslims and non-Muslims thereby resulting in an increase in the number of Islamic cbBanks (El-Qorchi, 2005). Despite the growth in the Islamic Banking Sector, the number of Islamic Banks in most countries remains relative small compared to conventional banks. Moreover, the Islamic banking sector in general remains very small when compared with the conventional banking sector (El-Qorchi, 2005).
Under Islamic Laws, the payment of interest is considered an immoral act. Therefore, one of the key differences between Islamic banking and conventional banking is that borrowing and lending transactions in Islamic Banks are interest free. Islamic finance products particularly target Muslim investors who are committed to complying with the strict principles of Sharia law that governs their day-to-day lives. Borrowing and lending transactions in Islamic banks are therefore conducted interest-free because Sharia law prohibits the payment of interest. Under this law, profiting on the exchange of money is considered an immoral act. Unlike conventional banks, which depend significantly on the receipt of interest as a principal source of income, the main source of return for Islamic banks is from investment in real sectors of the economy. Investment in sectors such as tobacco, alcohol, gambling and armament is also forbidden under Islamic law (El-Qorchi, 2005). Therefore, another difference between Islamic and conventional banks is that there is a limited amount of investment opportunities opened to Islamic Banks as opposed to conventional banks. Depositors in Islamic banks are regarded as equity investors rather than as creditors. They are allowed to share in the profit and loss of the bank (El-Qorchi, 2005). The return on an Islamic bank contract is therefore linked to the productivity and quality of the projects in which the banks invest in thereby making sure that a there is an equitable distribution of resources (El-Qorchi, 2005). Islamic banking products are structured in the form of contracts between customers and banks. Two main contracts are available. These include the Mudaraba and the Qard Al Hasan (El-Qorchi, 2005). Funds are provided by the customer to the bank who invests them in suitable investment projects (El-Qorchi, 2005; Vernados, 2006). The absence of interest in Islamic banks advocates an economy that is based on risk sharing, fair dealing and equity from a financial and social justice perspective (Vernados, 2006).
Islamic scholars consider an interest free society as a superior one for a variety of reasons. Firstly, they observe that the absence of interest advocates an economy which is based on risk sharing, fair dealing and equity, which in turn enhances prudential lending by encouraging investors to invest directly in an entrepreneur’s venture rather than deposit money in a bank for a very small amount of return. Virginia-based Islamic Scholar Shaykeh Yusuf DeLorenzo argues that: “A financial system without interest is more interested” (Vernados, 2006: 1).
A customer in an Islamic bank therefore has the opportunity to benefit from a growth in wealth if banks are doing well. On the contrary, conventional banks do not provide customers to benefit from growth in wealth. Rather conventional banks collect deposits and pay out a small interest to customers while investing in projects with very high returns on investment. The banks consider themselves as risk-bearers and thus deem it necessary to benefit from a high spread between the investment returns and the cost of capital.
Despite the differences suggested between Islamic and conventional banking, there are cases where it becomes difficult to make a clear distinction between Islamic and conventional banking products. Al-Salem (2009) argues that it is not a pre-condition that Islamic banking products must be completely different from conventional banking products in both legal substance and form. While interest is forbidden under Islamic Law, there are situations where some Islamic banks go against this rule and provide products that are not interest free. These tricks have been referred to by Islamic Scholars as: “rabawiyya tricks” (Al-Salem, 2009: 189). In addition to non-interest payment and receipt in Islamic finance products, currency, futures, and forward hedging transactions are forbidden. Islamic law considers it unethical for somebody to benefit from the uncertainty of another (i.e., ghakar). As a result currency hedging is not allowed (Vernados, 2006). Muhammad argued that “fish in the sea” or “dates that are still on the tree” should not be bought, which explains why futures transactions are forbidden. It is not clear whether Islamic banks permit bonds or not. On the one hand, the issuance of specifically designed “Islamic bonds” has been approved by Malaysian Islamic Scholars. However, on the other hand, bonds are not considered Shari’ah compliant financial instruments in the Far East (Vernados, 2006).
The foregoing indicates that Islamic banks cannot hedge against currency risks or any other risks that may affect the time value of their current base of assets. In like manner, customers who assets invested in Islamic assets cannot hedge against the decline in value of these assets, as doing so would mean not complying with Islamic Banking principles as enshrined in the Shari’ah Law. Apart from the lack of ability to hedge against risks of loss in value of assets, Islamic banks are characterised by a number of other issues. Islamic banks are also characterised by a number of other issues that makes their growth and development difficult. For example, Vernados (2006) suggests that lack of comprehensive and appropriate framework and instruments of regulation and supervision, limited market coverage, lack of knowledge and understanding on the part of the public, lack of efficient institutional structures supporting efficient Shari’ah banking operations, operational inefficiency, domination of non-share-based financing and limited capability to comply with international Shari’ah financial standards impede the progress of Islamic Banking in Indonesia. Another issue that has been facing Islamic banks is the fact that management of liquidity has been very difficult although this has started to change with the introduction of certain instruments that are acceptable under Shari’ah law. Conventional banks traditionally manage liquidity through asset-liability through the use of a variety of methods. The most commonly used approach is asset liability management techniques to manage cash flows on both sides of the balance sheet, revolving around re-pricing and duration of assets and liabilities (Vernados, 2006). However, imbalances may occur and asset-liability management may not be the best approach to follow. In situations where asset-liability management cannot function properly, banks typically turn to the “call money market” which constitutes the secondary market for debt instruments and the inter-bank market. In the secondary market, banks can easily buy and sell bills and bonds as a means of enhancing their liquidity position. In the inter-bank market, banks can easily borrow and lend on an overnight or longer-term basis thus enhancing their liquidity position. In addition, interest rate swaps are used as a hedging instrument against illiquidity which can arise if payment liabilities against deposits exceed receipts against loans and other assets (Siddiqui, 2008). The absence of similar structures under Islamic Banking principles makes the management of liquidity by Islamic banks difficult. The Islamic banking system lacks a secondary market where debt instruments can easily be bought and sold. Moreover, the institutional framework for a money market remained underdeveloped for many years (Vernados, 2006). Thus, while Islamic banks provide Shari’ah-compliant banking products to devout Muslims, there are a lot of issues that need to be addressed for successful progression of Islamic banking. The liquidity and credit of Islamic Banks compared to that of conventional banks depends on the institutional arrangements in place in the country (Siddiqui, 2008).
One similarity between Islamic and conventional banking is the concern for ethical investment. For example, an excess of £1billion is considered to be ethically invested in the United Kingdom (Wilson, 1997). Both ethical fund managers and proponents of Islamic Banking detest investment in tobacco production and distribution as well as investment in armaments. However, there are considerable differences as to some of the things that are considered under Islamic and conventional finance (Wilson, 1997). The underlying value systems of Western and Islamic economies are quite different. In Western economies, Cowton (1994: 213-32) cited in Wilson (1997) argues that ethical investment is “the use of ethical and social criteria in the selection and management of investment portfolios, generally consisting of company shares”. Apart from being concerned with the risk/return profiles of investment portfolios, ethical investors are also concerned with the characteristics of the companies in which the funds are invested.

4. Conclusions and Recommendations

Based on the discussion of the global financial crisis as well as an overview of the functioning of the Islamic banking and financial system vis-a-vis the conventional banking and financial system, a number of conclusions can be drawn. Firstly, the global financial crisis cannot be attributed to the conventional banking system. Rather, the crisis can be attributed to selfishness and greed on the part of bankers and other market participants who were involved in the sale of mortgage loans and underlying securities derived from these loans. The conventional banking and financial system is well organised and have enough tools to detect and manage risk. For example, futures and forward contracts are available which can be used in the management of currency and other types of financial risks such as interest rate risk and default risk. However, banks simply ignored these tools and focused only on the return that was to be generated from investment irrespective of the risk associated with the investment.

Given that the crisis cannot be attributed to the conventional banking system, it is therefore not right to conclude that Islamic finance could have helped in avoiding the crisis. The bottom line is that bankers were too self-fish and greedy. It is not an issue of the financial system, it is an issue of ethics. Some may argue that because Islamic banking does not use derivatives, the creation of mortgage-backed securities which led to the crisis could have been avoided. However, this is not a valid argument because, mortgage-backed securities are by themselves not inherently risky if proper rules for offering mortgage loans have been followed. The key issue is that most of the mortgages in issue during the run-up to the crisis were sub-prime mortgages. Banks simply issued to mortgages because of the short-term profit that was to be generated as a result of the high fees associated with underwriting the mortgage. Even in the presence of an Islamic financial system, bankers can be greedy and the system will not change things.

Due to the laws that govern Islamic Banks, there is a shortage of tools that can be used for the management of financial risk. An Islamic banking system would have exacerbated the crisis rather than avoid as risk management would have been impossible.

In the final analysis, this paper concludes that an Islamic Banking system could not have avoided the financial crisis. What we need are bankers who have a balanced between risk and return and not bankers who focus only on return. A financial system cannot avoid a financial crisis if those that function in the system are not committed to avoiding one. While a financial system can be characterised by rules that can avoid a crisis, it all depends on whether bankers and other market participants are willing to respect those rules.

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